Brexit chickens come home for sterling

Ian Kernohan

7 October 2016

It's been a difficult week for sterling. The three months since the referendum vote were a sort of limbo, with little detail on the government’s position re the trade-off between soft and hard Brexit. This allowed a residual opinion to take hold in some quarters that Brexit might not actually happen, or at the very least an EEA type arrangement would be found, which would keep the UK in the Single Market. Now the market has been shocked into a realisation that not only is Brexit very likely to happen, but the UK will also leave the Single Market and seek a bespoke trading arrangement, probably based on access for key sectors. This much, the Prime Minister had been hinting at all summer, when she spoke of a push for a “unique” agreement, yet it is apparent some hadn't been paying attention. Expectations have now been re-set.

Last week, we were reminded of the size of the UK's current account deficit, at almost 6% of GDP.

This is not a new story in itself, but capital inflows are needed to fund it, which argues for sterling to take the strain. What really spooked the markets however wasn't the deficit news, but a signal from the Prime Minister that the UK would trigger Article 50 before March 2017. This finally gave investors a timetable to focus on. To these comments were added hawkish remarks by various European leaders later in the week, and unhelpful comments by the PM about monetary policy, which were taken as a direct criticism of the Bank of England (BoE). A shocking picture of a UKIP MEP, sprawled on the floor of the European Parliament, added to the general feeling of Brexit malaise.

In making her remarks about monetary policy, which were then repeated by an advisor on the broadcast media, the PM was badly advised. There is a legitimate debate to be had about the distributional impact of the BoE's Quantitative Easing policy and ultra-low interest rates, indeed Monetary Policy Committee (MPC) members have been happy to engage in it. This should not stray into criticism of the Bank itself, or even give that impression. Since the BoE was given operational independence in 1997, the convention has been that PMs should be like The Queen when it comes to monetary policy matters: they may hold views, but they should be expressed in private. Also, as Alan Walters, economic advisor to former PM Mrs Thatcher, discovered in 1989, an éminence grise should avoid making public statements about economic policy. It only creates confusion about who is really in charge.

What happens now? First the government must stop giving the impression that they are critical of BoE. Such sentiments are self-defeating, at a time when the country is faced with a difficult transition period. Sterling will remain vulnerable to sentiment shifts on Brexit negotiations, however the market's attention towards this issue is bound to wax and wane - negotiations won't begin until next year and could run for two years. Meanwhile, the economic data has been much stronger than expected.

Not only has there been no post referendum recession, as widely forecast, but the UK should be one of the fastest growing major economies this year, with GDP growth close to 2%. With monetary policy loose, a very competitive currency and the prospect of fiscal stimulus next month, attention should soon turn to the cyclical impact of all this on the economy next year, at a time when global growth looks to be picking up, thanks to better data in US and China.

The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.